Sunday, March 02, 2014

RBC ain't dead!

[T]he basic] version of the RBC model is not really taken very seriously by researchers anymore — at least with regard to the role of productivity shocks. Better measurement has deprived the canonical RBC model of the innovations necessary to generate cyclical variations in economic activity...

Of course there are actual productivity shocks...but none of these seem to be responsible for substantial changes in employment or production...

[T]here may yet be situations in which the RBC model might be applicable. While modern advanced economies do not have business cycles that are driven by real shocks, other economies might. For example, suppose you wanted to analyze the economy of ancient Egypt...the RBC model might provide an interesting guide as to what patterns one might expect in the data. (If there is an enterprising student out there who has an idea of where we could find some actual data on production, etc. for ancient Egypt, send me an e-mail, I would love to write this paper with you...)

A while ago, Chris and I had a mini-debate about the degree to which modern macroeconomics takes data into account. If Chris is right, and RBC has been decisively rejected by the macro community, then it's a point for Chris, since it means that macro has the ability to discard theories that don't work.

So it's interesting to note this paper, just published by Ed Prescott and Ellen McGrattan, forthcoming in the American Economic Review Papers and Proceedings, titled "A Reassessment of Real Business Cycle Theory". The abstract:

During the downturn of 2008–2009, output and hours fell significantly, but labor productivity rose. These facts have led many to conclude that there is a significant deviation between observations and current macrotheories that assume business cycles are driven, at least in part, by fluctuations in total factor productivities of firms. We show that once investment in intangible capital is included in the analysis, there is no inconsistency. Measured labor productivity rises if the fall in output is underestimated; this occurs when there are large unmeasured intangible investments. Microevidence suggests that these investments are large and cyclically important.

So the inventor of RBC certainly doesn't think it's dead, and the AER, the top econ journal, is still obviously taking it seriously. (Note: AER Papers and Proceedings is a non-peer-reviewed section.)

But the survival of RBC goes far beyond such holdouts. TFP shocks - the driving force behind business cycles in RBC, and the part that Chris House says nobody takes seriously anymore - are central to a lot of more recent macro models. For example, Krusell and Smith (1998), possibly the first paper to make a serious attempt at a DSGE model with both heterogeneity and aggregate risk, uses TFP shocks as the driver of the aggregate risk. TFP shocks are also the main or only shock in a number of modern asset pricing, labor search, and international finance models (I won't even link to specific papers, there are so many).

I suspect there are two reasons why TFP shocks are still very much alive. The first is just that they're easy. If you want your model to be driven by demand shocks, you have to include stuff like Calvo pricing and imperfect competition - or even harder stuff. That makes life harder for the model-maker.

Second, since TFP shocks were the driver of the first DSGE model, they've become "canonical" - a sort of "default". TFP shocks were the first thing the DSGE people tried way back when, so it's the first thing today's macroeconomists try when they come up with some new wrinkle, like heterogeneity or search or habit formation. In macro, ontogeny really does recapitulate phylogeny.

So there seems to be a tendency for macroeconomists who come up with a new idea to say "Let's see if we can make it work with TFP shocks first". Thus, TFP shocks will live as long as DSGE macro itself lives.

Don't believe the haters, folks. Rumors of RBC's death have been greatly exaggerated.

I get that P&P papers are supposed to be short and not fully fleshed out, but even so the McGrattan & Prescott paper seems rather weak - it doesn't actually show what it claims in the abstract (that intangible capital fixes RBC). It just argues it potentially could, and further research is needed.

It's also interesting that in fall of 2000, McGrattan & Prescott used similar argument (taking into account intangible assets not captured in official statistics) to claim that stock market was not overvalued at the time [1]. Needless to say, that prediction didn't work out so well...

As someone who has criticized RBC models on a number of occasions I think they are alive simply because when I have done so, I have usually gotten some very vigorous pushback from folks who do not hesitate to inform me that I know nothing at all about "modern macro," with the use of that phrase generally speaking a loud signal that the user is a true believer in RBC models.

Noah, I repeat: a real business cycle model means just that- a model where only relative prices matters and, money illusion is of 2nd or 3rd order importance and money demand is easily satiated by a modern payments system (i.e a cashless/electronic money economy is a good approximation). Such an economy could be hit by sentiment/animal spirits shocks as in models by Angeletos and Lao or by Farmer, increases in investor and household uncertainty, increased distrust and uncertainty in financial markets showing up as financial shocks etc... A new wave of research by this guy http://www.econ.umn.edu/~vr0j/research.htmland coauthors is formally showing that TFP shocks are often isomorphic to demand shocks. In an economy with search and matching frictions in product markets, lower marketing and search for new products effort by consumers makes it harder to sell stuff with any given amount of labour and capital. This shows up in RBC models as lower TFP. The difference is in interpretation and some of the implications for government policy. In the sticky price Keynesian version of the world, firms are not selling as much as they wish because they're stubborn in adjusting their prices to lower demand. In the RBC model, firms are not adjusting their prices because they really don't think it would help them and the economist building the model isn't in a position to argue better(similar interpretation differences between the tendency of new and old keynesian modelers to put in sticky wages by assumption: there, it seems workers and employers would really really want to renegotiate a better mutually beneficial contract. An RBC modeler tends to try harder to find another reason for why aggregate labour supply looks sensitive to small average wage movements).Prescott is a hardcore hedgehog, but as others have said people who almost invent a paradigm tend to be less good at seeing multiple perspective and delivering well balanced analysis. Come to think of it, I've come to the conclusion that a certain class of MIT graduates like Krugman, De Long and Larry Summers are also hedgehogs but on the other side: somehow they're so convince of the wisdom of a certain version of Keynesianism that they feel obliged to trash RBC models wit the same dismissive attitude of Prescott and Barro to Keynesian models.

"TFP shocks are often isomorphic to demand shocks. In an economy with search and matching frictions in product markets, lower marketing and search for new products effort by consumers makes it harder to sell stuff with any given amount of labour and capital. This shows up in RBC models as lower TFP"

I think this is very true, and that RBC modelers thus misinterpret demand shocks and hence make the wrong policy prescription.

[Not that anybody should care, but I have been trying to make this point for years, falling on deaf ears, so I am pleased to learn some people do take a seriously]

“A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it.” -Physics Nobel Laureate Max Planck

The shorter version as applied to Macro: Economics advances one funeral at a time.-jonny bakho

Noah, You make a great point about people defaulting to certain ways of approaching a model. I see that also in the current debate from Nick Rowe focusing on Keynes' approach to try to formulate effective demand. I sense you implying that to really understand these issues, one must get out of the "default" box and keep searching for other explanations.I tie the two debates together with a new approach to measure effective demand as a function of labor share in relation to the % utilization of labor and capital. Productivity is guided by effective demand. Here is a chart to show this...http://effectivedemand.typepad.com/ed/2013/11/update-on-productivity.htmlThe chart shows that when output is up against the effective demand limit, productivity will just sit in one place for years. No shocks seem to budge it at that point. Then as effective demand expands during a contraction, productivity is able to increase. Even Prescott mentions in the first line of his abstract that productivity rose during the 2008-2009 downturn. Well, productivity rises as effective demand expands during a contraction. That has been the pattern for as far as I can see with the data.Therein lies the business cycle with regards to productivity.

Probably the chief remaining legacy of the RBC paradigm is the awful TFP-shock standard. I use TFP shocks in my models too, but that doesn't mean I think TFP shocks drive business cycles.

Part of the problem is that there's not an obvious alternative for a standard shock. Some NK models use a shock to discount rates to get a basic demand shock, which is similarly awful, though useful. What else are you going to shock in the baseline model? Preference for leisure? Expectations of future productivity? Capital depreciation rate?

Noah, it is my impression that you can represent pretty much anything with a TFP shock, including the financial crisis. A shock in TFP of the financial sector (e.g. in the cost of monitoring) reduced the marginal product of labor (e.g. in finance and construction) thus reducing demand for labor (especially in those sectors). The result is a drop in employment (due to intertemporal leisure substitution or, if you add search frictions, due to the drop in the number of vacancies). Of course, one may argue that this is a crude way of modelling what has really happened, and I would be inclined to agree, but this does not make the model any more or less wrong. The point is that if TFP shocks are defined broadly enough, the model becomes very flexible.

Yes, for A I should have said "a wide variety". But for B, does it not depend on the level of aggregation of the model? With a high degree of aggregation, are they not observationally equivalent? This is an honest question, by the way, in case you know. I am only expressing a hunch.

They are observationally equivalent only if you can only observe aggregates. For example, suppose TFP shocks to the nondurables sector are unimportant for business cycles but very frequent, while TFP shocks to the durables sector are crucial for business cycles but very rare. Then if you look only at the aggregate, you'll conclude that TFP shocks don't cause business cycles, because they'll only occasionally coincide...but if you know the structural model, you know that a certain kind of TFP shock does in fact cause business cycles.

There is a lot of handwaving and strong priors embedded within the ideas of TFP and sticky wages. These things may make your model work but that doesn't mean you have properly identified what that is. They are often used as fudge factors to crowbar a model into appearing real.

Noah: I must have said something similar in comments on Steve Williamson's blog, hence felt I was repeating a point which should be clarified before the next blogosphere or business economics commentariat member goes wild about those crazy academics with their ivory tower RBC models.Enrique: demand shocks that act like productivity shocks don't usually have the same implications for the effects of government spending or monetary policy like Keynesian demand shocks modelled with sticky prices or wages. They typically suggest more caution about the strength of the effects of traditional/conventional fiscal and monetary policies.Noah: you can model pretty much anything in a semi structural DSGE model using a combination of TFP shocks, labour wedge/tax shocks and shocks to the return to investment. It's called business cycle accounting, google it if you don't know. Is this truly satisfactory? No, not any more than shocking residuals to consumption and investment equations and calling them demand shocks should be satisfying in sticky price keynesian models (either DSGE ones or the old system of equations models a la Moody's economy.com)- people don't just suddenly become more patient on average. It's more likely that preference or "risk premium" shocks to representative agents are caused by sentiment shocks in a world with heterogeneous households and imperfect info, or caused by rising unemployment risk. Or maybe these shocks really are reduced form representations of time varying deviations from rational expectations yet to be microfounded by some canonical model of over/underreaction to information from behavioural economics/finance.So yes, you want to work with models where TFP shocks emerge endogenously due for example to higher misallocation of production inputs after a financial crisis or due to lower search effort by buyers and sellers in a recession. But given the difficulty of including all detailed micro channels in 1 single model, it's useful sometimes to have some sort of synthesis in a simpler model with a few key representative agents+reduced form shocks.

thanks daniels. yes you're right ... after writing that comment I immediately regretted it - expressed myself very poorly. I actually have something else in mind, a demand shock more like a shift between multiple equilibria. But I'm not going to try and elaborate here.

I am surprised anyone thinks that RBC is dead. I don't think they know academia...

First, a lof of these professors won awards (Nobels!) and got tenure. Then, even if evidence came in disproving their theory, they did what is natural in people-not changing their views that give them pride, importance, and most importantly, their livelihood. And it is not as if the Presidents and administration of University of Minnesota or Rochester were going to be like, "Ok, we did the research on this, we are the referrees, all you RBC cats were wrong, now we are going to fire you. Regardless of your Nobels" Not going to happen. Hell, professors that are a lot more crack-pot than RBCers are living large in academia. And who doesn't want to have a notable econ department? And to top this all off, RBCers are popular with rich benefactors, so can't attack a money source.

This kinda goes back to the comment above about Max Plank or was it Kuhn who thought that scientific knowledge has a strong generation ebb-and-flow component. I kinda wonder if something like this happened at the old redout of the RBC world, University of Chicago.

I don't think so. The theorists you mention have shown that TFP shocks, aggregate or sector-specific, can generate fluctuations in output whose behavior mimics much of the data. To say that they can is, of course, not the same as saying that the do. But nothing will be the same after this, because from now on and until we know better, the role of fluctuations in TFP as at least a contributing factor will be discussed in almost every recession.

Procyclicality of TFP, employment and real wage, lower SD of consumption, and so on.

Of course, there are other dimensions in which the model comes short. However, it goes far enough to suggest that a modified version (e.g. with frictions, greater heterogeneity, etc.) might get us further, and that some type of shock that can be represented as a TFP shock is at play (as opposed to, say, animal spirits). I do not think that the death of the people associated with RBC models will change this.

My crystal ball says that any attempt to understand business cycles for a long time to come will involve some model that evolved from RBC, like the New Keynesian models, so TFP shocks will continue to be considered one of several sources of instability.

This is where the problem lies, I think the way we think about empirical verification is too narrow, because we pretend we can resolve theoretical disputes in the same way as experimental sciences. I just finished a paper on this, partly inspired by our conversations. I would be happy to hear your comments if you have any time to read it.

By the way, among other things, we should completely give up modeling the labor market as Walrasian and from now on use search models. There is just no good reason not to.

I can see why RBC has a certain appeal. There are shocks to the economy such as the rising oil prices of the 70s or the manufactured shortage of money at the end of the decade. We even tend to get shocks to the economy when loan originating entities over-leverage some investment and wind up unable to originate loans. On the other hand, RBC tends to require arguments that anyone familiar with private business would find unrealistic or even bizarre. Heck, some of them, like the insistence that prices should change to clear the market automatically contradict basic rules of classical economics.

Of course, the real reason that RBC is around is that someone is still willing to pay for it as it advances their ideological agenda and allows them to recruit government intervention on their behalf.